IT BAFFLES ME that people often favor stock-picking over index funds—and yet they fail to measure their portfolio’s performance against a proper benchmark. I’m not talking about those who buy a few individual stocks for entertainment or education. For them, it’s a worthwhile pastime and the stakes are low.
But there are others who ignore the evidence and arguments against active management, and devote serious money to picking stocks and timing the market in hopes they’ll earn market-beating returns. This group includes a number of people I know—folks I otherwise admire for their intelligence, critical thinking and self-awareness.
These acquaintances are do-it-yourself investors who actively manage their investment accounts, and they do so with confidence. I’ve probed a little to find out what lies behind this confidence. My conclusion: Improper benchmarking is a common cause. In other words, many think their strategy has played out well, but—in reality—their investments have lagged behind an appropriate market benchmark. Why don’t they realize this? I’ve spotted two mistakes.
First, they’re misled by the outsized performance of a few stock picks. I have a friend from work, whom I’ll call Techie. A few years ago, he researched and bought a dozen stocks—all members of the popular Nasdaq 100 Index.
A few years later, Techie’s picks rode the bull wave upward. Two stocks did especially well, the rest not so much. The net result: Techie’s portfolio underperformed the indexes that his investments should have been benchmarked against. Yet the outperformance of the two picks, coupled with his portfolio’s overall gain, gave Techie false confidence in his stock-picking skills.
That brings me to the second error that I’ve seen drive overconfidence. This mistake affects people who make regular contributions to—and withdrawals from—their investment account.
At issue is comparing an account’s dollar-weighted return to a benchmark index’s time-weighted return. To illustrate the difference between the two, suppose you were inspired by Warren Buffett’s advice at Berkshire Hathaway’s 2004 shareholder meeting and started putting $100 in the S&P 500 each month. Ten years later, your account balance would have been close to $20,000, a handsome dollar-weighted return of more than 9% a year. But the standard benchmark return for the S&P 500 over that period was much lower—a time-weighted return of around 7%.
Why the difference? The time-weighted return assumes you bought at the beginning of the 10 years and simply held on. Meanwhile, the higher dollar-weighted return reflects the fact that you were buying regularly during a stretch when the market experienced a significant downturn and subsequent recovery. That sequence of returns would have bolstered your performance, because some of your $100 monthly investments bought the S&P 500 at very low prices. But you didn’t truly outperform the benchmark—because you were invested in the benchmark. The appearance of outperformance reflects not stock-picking ability, but rather the benefit of your mechanical dollar-cost averaging over the 10-year stretch.
This performance misinterpretation affected someone I’ll call Lucky. We both started at the same company in early 2000. We both put our annual bonus—a sizable chunk of our income—in our investment accounts. We both traded up to larger homes near the peak of the housing market in 2006. The down payment required us to sell investments at market highs. We also shared similar risk profiles.
The only difference between us is that Lucky had always favored stock-picking over indexing. He didn’t time the market or chase hot stocks. Instead, he put his money in large, well-known companies. He continued on this path because he thought he was consistently beating the S&P 500.
A few years ago, Lucky casually mentioned his consistent outperformance to me. We both use the same brokerage firm, which reports your account’s dollar-weighted return and compares it to popular market benchmarks. Lucky’s mistake: He didn’t read the fine-print and hence failed to realize that he was comparing apples to oranges—his dollar-weighted return to the S&P 500’s time-weighted return. My suggestion to both Lucky and Techie: Check that your stock picks really are measuring up—and consider index funds instead.
A software engineer by profession, Sanjib Saha is transitioning to early retirement. His previous articles include It’ll Cost You, Mind the Trap and A Rich Life. Self-taught in investments, Sanjib passed the Series 65 licensing exam as a non-industry candidate. He’s passionate about raising financial literacy and enjoys helping others with their finances.